Using ETFs To Build A Sustainable Muni Portfolio

Municipal bonds for investors have been spoiled. Through the years of the bull market in bonds, holding a portfolio of munis was typically a low-maintenance and low-risk endeavor.

But not anymore. For municipal bond investors, life is getting more difficult.

The change in the interest rate environment means that simply buying and holding munis to maturity may not be as rewarding as it once was.

However, because of the portfolio risks that can result from being poorly diversified, a rising-rate environment shouldn’t necessarily mean avoiding bonds. In addition, the growing concerns about underfunded pension obligations among bond issuers mean that credit risks are rising and that diversification is growing in importance as a risk management tool.

How ETFs Can Manage Risk

Fortunately, there are strategies that investors can use in a rising rate environment to protect existing income (in case rates go lower) while retaining the flexibility to take advantage of potentially higher rates in the future.

And the structure of ETFs and the available variety of muni-bond ETFs can help investors manage their muni portfolio risks and build a broadly diversified and low-maintenance municipal bond portfolio.

Many muni investors are familiar with the laddered portfolio strategy, in which the total muni allocation is divided equally across sequential maturities. For example, a $1 million portfolio could be set up with $100,000 in maturities from 1 to 10 years. A ladder strategy is interest rate neutral—it favors neither a rise in rates nor a decline in rates.

A laddered muni portfolio can be built using a mix of any of the existing muni ETFs.

Two Examples Of How To Build A Ladder

Below are two hypothetical examples, one using BlackRock’s iShares iBonds Term Muni Bond ETFs, which will all shorten in duration as time passes, reducing the interest rate risk, but also necessitating future reinvestment decisions as each ETF matures.

The second example uses VanEck Muni Index ETFs. Because these are managed to track an index with a duration target, the portfolio would be expected to maintain a fairly steady duration, and would not require reinvestment maintenance as the maturing iBonds would.

In both cases, because of the exchange-traded liquidity of the ETFs, should the need arise to rebalance either portfolio, doing so may be easier than with a portfolio of individual bonds.